Calculating Return on a house for rent

[Peter S.]

Hello all, I have a numbers based question that I can't quite figure out. I currently own my home and have a mortgage on the property. I am looking at potentially buying a new home and renting out my current residence. Since I purchased it in 2010, I have a low interest rate and overall payment. Is ROI the appropriate metric to use in this situation? If so what is the best way to figure it out? Or is there another formula I should be using to help me decide what to do?

[Mike H.]

I think some people here are confusing ROI with cash on cash return. There's a difference. And when you're just looking at cash on cash return, you're shortchanging the real return you get with buy and hold investing - SIGNIFICANTLY.

That being said, I think the poster is co-mingling the two homes and their values a little off as well.

You mentioned the 50k you're putting into the new home. At no point would that help you figure out whether keeping your current home as a rental is providing the returns.

If you want to calculate your returns, you should look at how much equity you have in your current home. Determining whether you should make your current home a rental or not is based on how much your return would be which is based on how much cash you'd actually walk away with if you were to sell it instead of renting it.

So lets say your house is worth 300k and you owe 220k. If you sell it, you may have to put in another 10k to get it retail ready and you'll end up with closing costs and realtor fees of say 20k?  So you'll walk away with 50k.

That is option A. Sell your current residence and pocket 50k.

Option B is keep your current house and rent it out. What does that return on that 50k?
1) Net rental income. 2700 for rent, with 1920 for PITI. Assuming you're going to self manage, thats 800/mo gross profit. Minus 200/mo for repairs and 250/mo for vacancy, that leaves 350/mo in net profit? or 4,200/yr.
2) Income is tax free.  If you have a 300k house, you will now be able to depreciate the house. Assuming you can get by calling land 20k, that would give you 280k divided by 27.5 years so 10k/yr in depreciation. You would basically offset the rental income of 4,200 against that so it would be 100% tax free. Plus you'd get an additional 6k tax writeoff on your regular income as well.  Maybe another 1,200 in tax refund?

3) Principal paydown. On a 200k+ loan in year 8, I'm guessing your principal paydown is roughly 400/mo?  Thats another 4800/yr you're making on principal paydown.

4) Appreciation. Lastly, appreciation. On a 300k house if you're getting typical appreciation of 3 to 4% a year, you're looking at 9k to 12k a year in that. Again, I'm guessing on the numbers for home value and mortg amount but based on rent and loan payment, I'm hoping I can at leave give you an idea of what the return actually is. 

So what is your real return on that 50k that you could pocket were you to sell versus what it would earn you as a rental.
1) Rental income - 4,200/yr

2) Tax benefits - 1,200/yr

3) Principal paydown - 4,800/yr

4) Appreciation - 10k/yr

Thats a total of 20k/yr that is getting added to your net worth every year. If you were to sell the house and pocket the 50k and put it in the stock market, could you match that return?

And thats only the return in the early going. Rents go up. principal paydown on a loan goes up. Appreciation goes up as 3 to 4% of 300k is 9k to 12k. In 10 years, that house may be worth 400k, and then you're looking at 12k to 16k in appreciation a year.

There's a reason why buy and hold is one of the absolute greatest wealth generators in investing you'll ever find. It does mean dealing with tenants so its not as easy as picking a stock and watching it. But you won't find a better return on anything out there when comparing it to buy and hold real estate.